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Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation Claudio Borio and Andrew Filardo Bank for International Settlements 13th Dubrovnik Economic Conference 29 June, 2007 1 Road map Do we need new theories of inflation? “Theory” Empirical evidence Policy implications and conclusions 2 Motivation “Over the past two decades, inflation has fallen notably, virtually worldwide, as has economic volatility. Although a complete understanding of the reasons remains elusive, globalisation and innovation would appear essential elements of any paradigm capable of explaining the events of the past ten years”. Alan Greenspan (2005) 3 Do we need new theories? No & Yes • No: Still, inflation is always and everywhere a monetary phenomenon! • Yes: Evidence is accumulating that the inflation process is changing in various ways. Today, we focus on the channels influencing goods and services markets, from a top-down perspective. 4 Stylised facts about global inflation Also see, Ciccarelli and Mojon (2005), Mumtaz and Surico (2006). 5 Some stylised facts about globalisation Direct and indirect channels important! 6 Some stylised facts – G10 wage shares 7 Inflation trend (BIS 2006) Globalisation has… … lowered the cost of disinflation … helped moderate business cycles … rewarded good policy frameworks … reduced downward rigidities … boosted central bank credibility 8 Inflation trend Globalisation has… … lowered the cost of disinflation 9 Inflation trend Globalisation has… … lowered the cost of disinflation … helped moderate business cycles … rewarded good policy frameworks … reduced downward rigidities … boosted central bank credibility 10 The cyclical component 11 The cyclical component • What is the role of global factors in the domestic inflation process? • We know that the inflation process has changed • To many central banks, domestic developments might seem sufficient to explain the changes. But are the domestic changes symptoms or are they truly the causal factors? • At this point, we are only starting to explore the key implications – many daunting puzzles remain. 12 The “theory” Country-centric vs globe-centric views Country-centric view Traditional view - Phillips curve - Domestic measures of slack matter - Monetary policymakers have tight control of the inflation process 13 Country-centric view Key assumptions: 1. Textbook flexible exchange rates or 2. Fairly closed economy - Limited substitutability (across products and factor inputs) - To the extent that the tradable sector matters, import prices are sufficient statistics 14 Globe-centric view Globe-centric view Newer view - Traditional Phillips curve not well specified - Global measures of slack matter - Monetary policymakers have much looser control of the inflation process 15 Globe-centric view Key assumptions: 1. Deviations from ideal flexible exchange rate regime (though not necessarily a fixed regime) 2. Globalised economy - high substitutability across products and/or factor inputs (Chen, Imbs and Scott (2004)) - Global capacity constraints for goods and factor inputs key 16 Exploring global output gaps Several Key Findings! 17 Top-down methodology Augmented Phillips curve approach Inflation f(economic slack) What measure of slack is relevant? Borio and Filardo (2007): “Globalisation and inflation: new cross country evidence on the global determinants of domestic inflation” 18 Key findings Country-centric benchmark specification shifting t c t 1 Gap t D t 1 inflation constant lagged inflation domestic output gap Estimated country by country, for sub-samples (1980:Q1-92:Q4 and 1993:Q1-2005:Q3); CPI inflation; OECD output gaps 19 Declining importance of domestic gap Sensitivity of inflation to domestic output gaps has fallen 20 Specification issue Gi U D t t c Gapt 1 Gapt 1 t De-trended inflation constant domestic output gap global output gap Far from perfect, but instructive and illustrative 21 Global gaps – measurement issues 5 different alternatives Gi Gap j kK Gi D w j , k Gap k Weighted average of domestic output gaps Various versions eg trade weighted , FX weighted 22 Global gaps Trade-weighted version – W1 W1 j,k w import j,k export j , k total imports and exports j 23 Global gaps Import-weighted version – W2 W2 j,k w import j,k total imports j 24 Global gaps Exchange rate-weighted version – W3 W3 j,k w f j,k f j,k where f j,k j,k 1 exp m 2* j,k 1 1 exp m j , k correlatio n( US bilateral exchange rate for countries j and k) 25 Global gaps Exchange rate adjusted trade-weighted version – W4 import W4 j,k w j, k export j,k total import export (numerators) f j,k 26 Global gaps GDP-weighted version – WG WG j w GDP j World GDP 27 t tU c GaptD1 Pooled regression evidence: Scatter plot with global gap GaptW12 GaptW12 1985-2005 Now 1972-1992 28 Rising importance of the global gap Pooled 16 OECD Countries Coefficient on global gap 29 Rising importance of the global gap Average of 16 OECD country-specific regressions ( ) 30 Robustness to control variables Accounts for traditional and non-traditional control variables t ... control variables t U t Domestic variables Import price growth Oil price growth ULC growth Supply/cost shocks Global variables Global unit labour costs Global WPI 31 Global input prices and inflation – tight correlation Inflation gap: de-trended CPI inflation, 16 OECD economies. Input prices: Composite JPMorgan Chase input price index covering purchases of goods for manufacturing industries, and goods and staff costs for service industries; values above 32 (below) 50 indicate an increase (decrease). Goods and services markets Some evidence on sectoral markets: The correlation of global measures of slack with manufacturing is generally stronger than with services … as might be expected! 33 Tentative conclusions Prima facie evidence that we may need to think in a less country-centric, ie more globecentric, way about the key determinants of domestic inflation – direct and indirect channels of influence important This may help to explain the deterioration of domestic output gap estimates of late, and to suggest ways to “fix” existing models And, globalisation may be making domestic monetary policy less effective! 34 Policy implications 1. Globalisation has altered traditional policy guideposts Domestic slack has become less reliable Global slack has become more important determinant of domestic inflation Other dimensions of globalisation exacerbate these changes – NAIRU, natural rate of interest 35 Policy implications Policy challenge: - relying too heavily on domestic slack can lead policymakers astray - Looking forward – key risk is global spare capacity and price stability. So far a safety valve. - But what next? 36 Policy implications 2. Financial globalisation complicates this - Financial globalisation has weakened the link between policy rates and market rates - Room for manoeuvre may be shrinking - At the current policy juncture, this tendency may have implications for financial imbalances 37 Current policy implications Smooth sailing or impending crisis? Money, Credit and Asset Prices 38 Mitigating the global implications 1. Globalisation has altered traditional policy guideposts - improved monitoring of external developments 2. Renewed interest in boosting analytic efforts to understand the many facets of globalisation i. International business cycle models • Spillovers across national borders • Trade linkages as well as contestability ii. Top-down approaches rather than bottom up iii. Global dimensions of the monetary policy transmission mechanism 3. Multilateral policy implications 39 Important puzzles – top-down approach Specification issue & robustness (BF) (AR) Gi U D t t c Gapt 1 Gapt 1 t Gi D t c t 1 Gapt 1 Gapt 1 t 40 Conventional AR model severely bias! 20 15 AR 10 5 5 0 0 0.1 0.3 - - - “true” value AR BF 0.5 0.7 15 10 -0.1 , 20 0.5 0.7 0.9 -0.3 -0.1 0.1 conventional AR specification 0.3 B-F specification Small-sample probability density function 41 more Think globally! Act locally! Thank you 42 References Borio and Filardo (2007): “Globalisation and inflation: new cross country evidence on the global determinants of domestic inflation” and references therein; BIS Annual Report (2006). Recent speeches: Weber (June 2007); Kohn (March 2007), Bernanke (March 2007) Recent papers: Pain, Koske and Sollie (2006) Castelnuovo (2006) Ihrig, Kamin, Lindner and Marquez (2007) Razin and Binyamini (2007) 43
